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Economic Perspectives 15 – “Demand stimulus unmasked”

There is nothing intrinsically wrong with being “contrarian” when dispelling a myth – especially one which conventional wisdom believes to be true.

On 30th March 1981, for example, 364 academic economists famously sent a round-robin letter to The Times, roundly condemning the budget that Margaret Thatcher and her Chancellor, Geoffrey Howe, had just delivered. They expressed their unequivocal conviction that “there is no basis in economic theory or supporting evidence for the Government’s belief that by deflating demand they will bring inflation permanently under control and thereby introduce an automatic recovery in output and employment. Present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.”

Its timing was exquisite. Almost from the moment the letter was published the economy, as if with a will of its own, embarked on a prolonged phase of vigorous growth.

Its timing was exquisite

So what went right? That budget was certainly not a timeless, classic prescription for curing economic ills. Despite fierce opposition from within her own ranks, Thatcher managed to balance the painful measures the economy demanded with what a desperate public would tolerate. We should also bear in mind the backdrop of record-high unemployment; public borrowing through the roof; interest rates in the ‘teens; declining industrial output; and inflation close to 20 per cent. The budget was therefore ultra-specific to the circumstances.

But the real point is that Thatcher, Howe and their closest advisers chose to risk public scorn by trusting their own grasp of what was desperately needed to restore growth, rather than follow the shibboleths spouted by a generation of benighted scribblers. Indeed, one of the budget’s most derided measures was to increase the tax haul by freezing differential tax-rate thresholds – and the additional revenue facilitated a much needed fall in public sector borrowing and interest rates.
Far from thrusting the economy into a self-perpetuating downward spiral, it was a prelude to eight years of uninterrupted growth and, with inflation at last coming under control, it left all those economic critics bewildered and discredited. It came to be considered the Thatcher government’s finest hour and its most widely acknowledged success.

Lesson: No matter how plausibly it is presented, conventional thinking may not have the answer this time.

Another reminder of failed groupthink: readers will also recall what happened when, at the height of the 2008/9 financial meltdown, the Queen attended the opening of a new building at the London School of Economics. Referring to the turmoil in the international markets, she asked, “Why, if this thing is so big, did no one see it coming?” The LSE’s own Professor of Economic Research replied: “At every stage, someone was relying on somebody else and everyone thought they were doing the right thing.” (Later, Prince Philip helpfully added: “Well, don’t do it again!”)

But they have been doing it again, in spades! Consider the prominence now given, everywhere, to the role of central bankers in framing economic policy, including the power to set interest rates, effectively subsuming the role of the Treasury.

Fear of deflation

For example, every time prices begin to fall, for whatever reason, central banks, like lemmings playing “follow-my-leader”, will react by applying policies designed to overcome their demon, which is “deflation”.

lemmings playing “follow-my-leader”

Their fear of deflation is in itself understandable. It’s based on the logic that falling prices, per se, imply lower turnover and lower profits for businesses. Every fall in turnover is, of course, followed by a reduction in production costs, but this happens only after a time lag. In the meanwhile wages will be squeezed, unemployment will rise and businesses will finish up unable to repay their debts, ushering in a wave of bankruptcies.

But consider: prices may fall for a variety of reasons other than deflation, just as prices may rise for reasons other than inflation. Labels are inherently misleading. The reality is that we all benefit from having a lower cost of living and are bemused by the central bank’s seeming determination, no matter what, to avert it.

A decline in consumer spending is only one reason why prices may fall. But when prices fall due to, say, increased production, that is not deflation. Or when prices fall following the introduction of improved production methods, advances in technology or enhanced efficiency, that too – assuming free competition and stable money – is definitely not a symptom of deflation, and it does not, of itself, pose an added risk to the ability of businesses to repay their debts. Therefore, in such circumstances, what is the central bank to do? The answer: “Nothing! Resist the temptation to fix what isn’t broken!”

The “stimulus” of printing money

When, on the other hand, the economy is faltering from low productivity and sluggish growth, however caused, central banks’ panacea is to apply a “stimulus” in order to stoke consumer demand. Their standard technique for achieving this is to conjure up and dispense loads of unearned purchasing power, the euphemism for which is “quantitative easing” (QE).

the truthful description is “capital destruction”!

It is really nothing more sophisticated than the age-old credit expansion laxative that is now being applied, in various guises, by the US Federal Reserve, the Bank of Japan, the European Central Bank (ECB), and the Bank of England, all to no avail. Mario Draghi of the ECB likes to refer to this practice as “asset purchases” – which actually sounds like something sensible, when the truthful description is “capital destruction”!

As noted in previous issues of Economic Perspectives, this stimulus procedure turns Say’s Law on its head. Say’s Law observes the fact that we produce goods so that we are able to acquire the things – goods, services – that we need in order to live. Or, more simply, “we produce in order to consume”.

Demand for goods and services to satisfy our needs and desires is a feature of human nature, and consequently the attempt to “stimulate” what already exists, everywhere, in abundance, is patently absurd. This was recognised with notable success in the early Reagan/ Thatcher years under the expression “supply-side economics” when they at last recognised the utter pointlessness and futility of demand-side stimulus.

Malign effects of applying artificial stimulus.

1 – The Cantillon effect

Richard Cantillon, writing almost 300 years ago, described how the artificial creation of new money drives up prices as it is spent. Its “first receivers”, banks and other financial houses close to the central bank, benefit by being able to spend it, usually on property and all manner of glitzy baubles, before the general price level rises, as it must. Those at the end of the chain, by contrast, suffer the full impact of the inflation in prices.

2 – The timing effect: capital destruction

Receivers of the free credit can obviously use it only to “buy” goods that already exist; goods that, in other words, are already part of the nation’s capital. While the production of replacement goods using the new “free” money may replenish the capital consumed when it was originally produced, it can never add to the nation’s stock of capital.

Here lies the irrefutable proof of why any system of demand management that relies on conjuring money from nowhere MUST fail to meet the objective of increasing the nation’s wealth. For that, fresh capital is required.

And finally…

As bogus money filters through the system the consequences of credit expansion are evident. It pushes up prices, generating a paper profit that is needed to replace the assets consumed; yet is taxed as if it represented genuine gains, further impairing the ability of firms to replace their assets. To quote the insight of George Reisman: “The destructive consequences of this phenomenon can be seen in the transformation of what was once America’s industrial heartland into the “rustbelt”.

Lesson: The Bank can produce more and more fake money by expanding credit – but fake money can never add to the nation’s capital. Instead it eventually consumes capital, causes interest rate distortion, malinvestment and inflation. There may be a time delay, but the consequences are inescapable. It also destroys the possibility of any meaningful economic calculation.

————————————————————————————–[As an aside, none of these shenanigans could occur if the currency is, even notionally, “convertible” into gold at a fixed rate of exchange.

But it is the unquestioned creed of most modern economists and treasury departments that central banks should possess the flexibility to indulge in credit expansion whenever it considers that it is warranted by the state of the economy. They dislike the discipline of a system under which the purchasing power of paper money is preserved by establishing a fixed relationship with a stable commodity such as gold or silver.

The trouble, however, is that throughout the history of money Barron’s Law is seen to come into play: “Any government that can print money will print money”. The urge is irresistible and unstoppable. As an example, since the USA abandoned gold convertibility in 1971, the price of gold has moved from $35 to $1,260 per ounce – an inflation of 3,600 per cent, or an average rate of 78 per cent for each year since 1971 – the year the Fed embraced untethered credit expansion.

That is also the measure of the loss in the dollar’s purchasing power over that period – and that’s still miles away from hyperinflation!]
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